International Diversification

I suggested in a recent email message that you avoid reading Chapter 13 in Bekaert and Hodrick. This chapter is tedious and its main points can made in a much briefer manner. Serendipitously, an article from today's WSJ titled "Swimming with the Currency " is very helpful. The article touches upon several points

First, when investing in a foreign investment, the rate of return in terms of the domestic currency (say USD) is affected by both the performance of the investment in the foreign asset (stock or bond) and the performance of the foreign currency itself (see my December 17 email message). Let me pick an example from this article relating to results of investing in the Brazilian stock market (the Bovespa index). During 2008 the Bovespa declined 41% in local prices and the Brazilian real lost 55% of its value against the USD. This means a total loss of 73.45% (compute!!!)

The second important point in this article is what it calls geographical diversification. Modern portfolio theory tells us that the more assets you include in your portfolio, the better are the risk-return opportunities. If you remember the mean-standard deviation capital market line, this means that the slope of this line is steeper when more assets are included. In short, don't attempt to outperform your domestic market by investing in foreign stocks. Do so in order to mitigate domestic market's variability. Hopefully, when your domestic market performs badly, foreign ones might mitigate this loss.
A few additional observations about international diversification:
1. The lower the correlation between the rates of return between the domestic and foreign markets, the better are the diversification opportunities. See page 465 for a tabulation of the historical correlations between various economies (Exhibit 13.5). Which countries seem to be good vehicles for international diversification?
2. Although you can't see it from Exhibit 13.5, these correlations tighten over time. Because we live in a global economy, all local economies are interrelated and are becoming more so with time.
3. What is the meaning of a "foreign" company anyhow? Is Toyota a foreign company? a huge part of its production and sales take place in the U.S.

The third important concept in this article is called translation exposure which is completely ignored by Bekaert and Hodrick. Here is the gist of this concept. According to GAAP (Generally Accepted Accounting Principles) U.S. corporation should consolidate the financial results of their subsidiaries --including foreign subsidiaries). When a the currency of the foreign subsidiary appreciates against the domestic currency, the subsidiary's assets appreciate. This appreciation enhances the parent corporation's income for the year. Obviously, the opposite might happen and profits could be dampened.